Many value investors make their investment decisions based on the quality of management.
Warren Buffett: "When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever."
But for many of us, it is not easy to get in touch with the top management of interesting corporations. Therefore, we have to resort to other criteria to identify a good management.
What is a good management?
Warren Buffett asks himself three fundamental questions in this regard:
1. Is management rational?
2. Is management honest with its shareholders?
3. Does management resist the institutional imperative?
(Robert G. Hagstrom: The Warren Buffett Way)
In his approach, Buffett wants to find managers who think like owners and thus always have shareholder value in mind.
All fine and good, but how do you answer these three questions? We would approach these questions from two different directions.
Are managers good capital allocators?
Capital allocation is the "allocation of capital, mostly equity, to individual divisions of a company." (BCG article – The Art of Capital Allocation)
Good and bad capital allocation can be easily separated. Good capital allocators use the company's cash flow in growing and profitable business units, bad capital allocators burn the money in unprofitable business units.
A management consisting of good capital allocators thus manages to increase shareholder value quickly. Good capital allocators can be assumed to act rationally and to be able to resist the institutional imperative. As an aside, the institutional imperative is "the lemming-like tendency of managers to imitate the behaviour of others, however stupid or irrational it may be" (Robert G. Hagstrom: The Warren Buffett Way).
So how can the ability to allocate capital be recognised or even measured? In my opinion, a good indicator is the return on equity. A consistently high return on equity that has been increasing over the years indicates some ability on the part of management in the area of capital allocation. In addition, return on equity can be seen as the "return" on shareholders' equity and thus allows conclusions to be drawn about the development of shareholder value.
The use of cash flow for share buybacks can also be used here for evaluation. There are good and bad times for share buybacks. If the shares of one's own company are currently cheap on the market, a share buyback programme makes sense. However, if the shares are grossly overvalued, a share buyback programme would tend to destroy shareholder value. Good management can distinguish between a good and a bad share buyback programme.
What psychological incentive systems are management subject to?
The question of the sincerity of the management is rather difficult to answer. In general, it is advisable to read the shareholders' letters at the beginning of the annual reports and to compare them with earlier ones. Were mistakes openly addressed? Were things that were announced actually implemented? Nevertheless, the assessment will probably always remain slightly fuzzy.
However, the question of sincerity can also be somewhat avoided. After all, if the interest of the management is also in line with the interest of the shareholders from the beginning, one can assume that the management makes shareholder-friendly decisions, analyses mistakes and wants to achieve the best for the owners of the company. This is the case when the managers of the company are also shareholders themselves.
That is why it is always worth looking at the company's shareholder structure and the shareholdings of top management. We are not talking about token shares worth USD 500. It is always good for investors if a "huge" part of the senior managers' wealth is in the company's shares. If the company's own management is itself one of the largest shareholders, it will also demonstrate shareholder-friendly corporate governance, which is reflected in dividend distributions and meaningful share buybacks.
The psychological incentives to increase shareholder value are strongest in family businesses. After all, they themselves are a large part of the shareholders. It is therefore not surprising that many successful companies are family-owned. One example is the he world's largest independent lubricant manufacturer FUCHS Petrolub: CEO Stefan Fuchs is the grandson of FUCHS Petrolub founder and owns 51.7% together with all members of Fuchs Protective Association of the outstanding shares. (FUCHS Petrolub Investor Relations)
FUCHS Petrolub generated a return of over 22% per year for its shareholders from the beginning of 2011 until today.
Family businesses are a great thing.
Warren Buffett, Bob Iger, Ajaypal Singh Banga and Tim Cook
The most obvious manager in this list is probably Warren Buffett himself. While Berkshire Hathaway has never paid out a single cent in dividends, there is hardly a manager who can hold a candle to Warren Buffett in terms of capital allocation over such a long period of time. What makes him so special is that since 1965, through successful investments, he has generated an average return of 23.45% p.a. for Berkshire shareholders. (Warren Buffett's Letters to Berkshire Shareholders 2020) That is a sensational value. Moreover, he also buys back his own shares when they have reached about 120% of book value. Therefore, he sets a good example and sticks to his conditions for good management listed further above.
Another excellent manager is Robert "Bob" Iger, and was the CEO of Disney. He has been at the helm of the company from 2005 until 2020. He has not only managed to realign the company with the acquisitions of Pixar, Marvel, Star Wars and Fox, but is also steering the company in the right direction according to the trend towards streaming. In addition, there has been a diligent share buyback programme for years, which has benefited shareholders during the long period of undervaluation of Disney stock. What further distinguishes Iger is his open and honest communication, coupled with a moral and ethical code.
"The 66-year-old executive has earned a reputation as a steady hand in an industry dotted with embarrassing R-rated voice mails and mercurial phone-throwers. I'm the conscience of the company," Iger has said. "We don't have a chief ethics officer, and I consider that one of my responsibilities." (CNBC article - A master class in the magic of success from Disney CEO Bob Iger)
The CEO of MasterCard Ajaypal Singh Banga is also a good example of excellent management. He himself owns over 60,000 shares in MasterCard. One can assume that this alone means he cares a lot about the company's success. Since Banga has been at the helm of MasterCard, both the profits and the dividends of the company have increased. During his tenure, the company has also bought shares back.
Since the passing of Steve Jobs (2011), Tim Cook has been at the wheel of Apple. He has also taken over this role on an interim basis when Jobs took time off due to his cancer. Even though Tim Cook failed to convince Warren Buffett to buy an I-Phone. "Tim Cook sent me a Christmas card again ... saying he's going to sell me an iPhone this year," Buffet said. "He keeps sending me these reminders every Christmas." (cnet article - Tim Cook failed to sell me on iPhone, says Warren Buffett)
He probably convinced him on other levels. Steve Jobs was not exactly known for caring much about shareholder value, which is why there were only moderate attempts to buy back his own shares in his time. Since Tim Cook, things have been different and share buybacks have played a big part in increasing shareholder value. In addition, Tim Cook has an incalculable stake in Apple shares of around 3,279,730 shares (as of August 2021), which are worth around USD 470 million today.
In the end, assessing management is not easy for private individuals and small investors, but there are ways to get the right impression.
By looking at management's capital allocation skills and psychological incentive systems, one can find out whether a company is being run rationally and in the best interests of shareholders. This is helped by looking at the return on equity and share ownership of the board, reading shareholders' letters and also evaluating share buybacks and dividend pay outs. If you analyse these points in more detail, it is possible for everyone to get an approximate assessment of the quality of the management - even if you cannot simply meet with the CEO for a drink in the beer garden.